Why is inflation reflecting into a strong dollar?

14 mai 2022

You may have often seen us mention the U.S. Dollar Currency Index (DXY), as it has significant negative correlation to Bitcoin (BTC). Meaning typically when DXY is up, BTC is down, and vice versa. Over the past month, the DXY has broken out from its resistance and made highs not seen in twenty years. The DXY is a measure of US Dollar strength against a basket of its foreign peers.

Euro (EUR), 57.6% weight
Japanese yen (JPY) 13.6% weight
Pound sterling (GBP), 11.9% weight
Canadian dollar (CAD), 9.1% weight
Swedish krona (SEK), 4.2% weight
Swiss franc (CHF) 3.6% weight

(Note that other world currencies like the ‘Chinese Yuan’ and ‘Brazilian Real’ are not included in the DXY)

The DXY strength

Let’s begin to examine why the US Dollar (USD) has seen significant strength since 2021. First, the US Federal Reserve was not the only Central Bank in the world that increased money supplies in an attempt to ease economic uncertainties of the COVID pandemic. The European Central Bank, Bank of Japan, Bank of England, and many other central banks around the world followed similar monetary policies, commonly referred to as Quantitative Easing. Notice these same banks (ECB, BoJ, and BoE) are in charge of monetary policy for the largest weighted currencies in the DXY.

Your layman might ask: “Why is the dollar so strong, if inflation is so high? Shouldn’t I not want to be holding fiat in times like these?” And the answer was yes — when the Federal Reserve began printing COVID stimulus cash in 2020. But as global markets soften, the safe heaven has always been to flee to cash.

The USD as a reserve currency

This is because the USD has been the world reserve currency since Post World War II agreements and the establishment of the ‘Brentton Woods System’. As the world began to rebuild post war, as trade and commerce returned — the US dollar’s strength as the world reserve currency was hardened. Even as the US broke terms of the Brentton Woods System, when Richard Nixon took the US off the ‘gold standard’ (a standard that meant that USD was convertible to gold bullion), the Dollar had already cemented itself as the means in which debts would be issued and commodities would be traded in, around the world.

Which leads us back to ECB, BoJ, and BoE. If the Fed is printing dollars, and the largest central banks are doing the same, that negates the negative effects on the increased USD supply compared to its peers. In fact it increases USD demand. If debts around the world are most commonly issued in USD, these same central banks need to continue to print their currency to keep up with the demand to convert to USD and pay these debts, creating a vicious cycle that exacerbates effects further.

Once the world economies are through the hangover of stimulus injection, the United States is expected to bounce back the soonest. When it does, investment will return and rush to growth sectors. And again, putting further strain on dollar demand. This is significantly dangerous to all sovereign debt, as the USD rapidly appreciates within the next few years, and its peers experience massive devaluation. Described like a straw sucking a milkshake, all of this pressure is expected to pull liquidity into the United States creating an unsustainable vortex.

‘The Dollar Milkshake’ theory

This is the foundation of the ‘Dollar Milkshake Theory’ popularised by Brent Johnson of Santiago Capital, and it is exactly why you need to be very cautious of the Dollar Index as it breaks out from resistance. This theory really makes you rethink the Dollars strength as the world reserve currency.
Suddenly, DXY trading at $120 doesn’t sound so far-fetched.

I implore you to read more on the ‘Dollar Milkshake Theory’. I find it the most fascinating theory in finance currently, and it summarises the Dollar Index strength we have seen so perfectly.
Take a visit to the team at Real Vision Finance, who exceptionally explain this theory better than I can.
While watching it, keep in mind this was published in September of 2021, when the DXY was trading at $92 and just starting the breakout from its ‘double bottom’.
Then make sure to follow the Milkshake Man himself, Brent Johnson’s Twitter @SantiagoAuFund. Brent mostly follows traditional markets, but you will see him from time to time mingle with the Crypto Twitter crowd. Drink up and don’t forget to read the rest of the Fundamental Fridays articles!